Unfixed Income

July 9, 2013

Dear Investor:

With the stock market suffering a nearly 8% correction on fears of Fed tapering, the bond market also suffered dearly. The difference is that stocks, reasonably priced and with organic underlying growth prospects, will recover; long-duration bonds will not. People often say a bond held to maturity has no loss. This ignores the opportunity cost of owning low-yield bonds in a higher interest rate environment.

As even Bill Gross of bond manager PIMCO said recently, the great 30-year bull market in bonds is over. Investors in bonds can only expect to get the minimal coupon yield on short-duration bonds – and the slightly better coupon minus capital losses on long-duration bonds. Simply put, bonds are likely to produce a negative real return, net of inflation, over the next decade.

That doesn’t leave many options for investors except to bulk up on stocks. With consumer staples stocks having gained more than 17% year-to-date, they are no longer cheap, but the power of dividends will still give them a better long-term return than bonds.

The power of dividends is largely unappreciated. Consider a stock like Procter & Gamble (PG). PG paid out $6.4 billion in dividends over the trailing 12 months, which amounted to a 2.9% yield. In other words, PG paid out $2.9 for every $100 invested. The glorious aspect of dividends is that successful companies increase them year after year. PG has increased its payout by an average of 11% per year over the past decade, while the number of shares outstanding has only increased by 1%. If PG were to replicate history and increase its dividend by 10% going forward, dollars paid out for every $100 invested will rise according to the following schedule:

2014:        $3.19

2015:        $3.51

2016:        $3.86

2017:        $4.25

By the end of 2020, the dividend will have doubled, to nearly $6.00 for every $100. If the stock price were to stay flat for those seven years, the yield would be 6%. But of course, it won’t: the stock price will rise as buyers bid up the price to take advantage of the rising yield. This is the basic reason stock prices go up over time, as increasing dividends tempt investors into juicier yields.

If you’re in a 10-year 2.9% bond yielding the same $2.90 for every $100, you will get the same $2.90 each and every year for the 10 years. In the seventh year when stock investor has double the payout to $6.00, the bond investor has the same $2.90. You can see why stocks are decent hedges against inflation while bonds are not. You can also see why they call it the “fixed” income sector.

The only power investors can harness here is the rising dividend yield, “unfixed” income — which is the same one responsible for the stock market’s great gains over the past century.